Speech
Banking – The Changing Scene

Introduction

It is traditional to open this conference with a summary of the state of the banking
system, as seen from the RBA's perspective. I will therefore do that first.
Then I would like to make some points about the prudential supervision of bank
capital. Finally, I will draw out some implications of the Government's
recent financial system policy announcements for competition in banking and
payments.

State of the Banking Industry

The banking system remains healthy overall but banks are under strong pressures from
new competitors, the cost of systems development and shifts in the structure
of financing.

Interest margins have been squeezed further over the past year, both
by the continuing intense competition in home and corporate lending and by
the low (and falling) levels of interest rates. Domestic net margins have
fallen to just under 4 per cent for the major banks (compared with 5 per cent
in the late 1980s), and to around 3 per cent for the regionals.

Notwithstanding this squeeze, major banks' after-tax profits
were around 17–18 per cent of shareholders' funds in the first half
of 1997, much the same as their 1996 result. However, for regional banks,
which are more reliant on home loans, return on equity fell from around 15
per cent to 13.5 per cent.

Capital ratios declined further over the past year – helping
to bolster rates of return – due to acquisitions, asset growth and capital
buybacks. The average risk-weighted capital ratio across all banks was 10.3
per cent in June, compared with 11.1 per cent in June 1996 and 12.1 per cent
in June 1995. (The ratio for the major banks fell from 10.6 per cent to 9.8
per cent over the past year, for the regionals from 12.4 to 10.8 per cent,
and for foreign banks from 15.1 to 14.8 per cent.)

Securitisation of bank assets has increased as a means of reducing
required capital, or freeing it up for other uses. In the past year and a
half around $3 billion of assets have been moved off balance sheets in this
way. (Of course, bank balance sheets are only one source of assets for the
expanding securitisation market – total assets in securitisation vehicles
would now be over $20 billion, double the level of two years ago.)

Bank credit (net of securitisation) has grown at an annual rate of
around 10 per cent so far in 1997, compared with about 12 per cent during
1996. The main categories have all grown at close to this average.

Asset quality is in good shape, with impaired assets at 0.8 per cent
of assets in June 1997, compared to 1.1 per cent a year earlier. Loan write-offs
have continued to fall, and loans newly identified as impaired each quarter
remain both low and steady.

Banks are responding to margin-squeeze on several fronts. There has been further
unwinding of the longstanding cross-subsidisation of transactions and account-keeping
services out of interest margins. There is a continuing drive to cut costs
– through rationalising branch networks, trimming management structures
and investing in labour-saving technology. This has included closer investigation
of the potential savings from outsourcing non-core activities (such as cheque
processing and information technology) and sharing basic facilities, and the
past year has seen some important initiatives of this kind.

Regional banks, in particular, are looking to diversify their loan portfolios to
reduce their dependence on home lending. But all banks are, to varying extents,
pursuing a wider range of revenue sources as competition intensifies in traditional
business lines, and areas such as funds management seem to offer better long-term
prospects. Through acquisitions and organic growth, the ratio of banks'
funds under management to balance sheet assets has risen to around 30 per cent
from 20 per cent four years ago. (Despite these efforts, it is interesting
that there has been no increase in the ratio of banks' domestic non-interest
income to domestic assets.)

The closer management of bank capital has been another notable feature of the past
year or so. One result has been the major banks' share buyback programs
and the repurchasing/restructuring of subordinated debt. The RBA has a keen
interest in these developments, given the centrality of capital in our supervisory
system. Closer alignment of capital with risks inherent in a bank's activities
(and prospective balance sheet growth) is, of course, not to be discouraged.
A banking system with excessive capital will be less efficient and less competitive
in performing its financing role for the economy. Supervisors will, however,
always wish to be satisfied that capital ratios take full and proper account
of all the risks inherent in a bank's business. I will talk more about
supervision of capital in a moment.

Speculation about a decline in lending standards under competitive pressures has
also been topical in the past year. It is very difficult to get any objective
reading on this. As I have noted, the statistics on impaired loans show no
sign of any such decline. Problems, if there are any, will be revealed in these
data only in the future. What our supervisors do have, however, is a clear
impression of a fall in lending standards – an impression based
on both market anecdotes and our observations of credit management in practice
during visits to banks.

Competition has not only whittled away margins but has led to relaxation of conditions
placed on borrowers. This applies especially in lending to large corporations.
But in the housing market, too, the imperative to maximise volumes or minimise
costs in the world of tighter spreads, creates a temptation for banks to take
short cuts. Two of the more common deficiencies we see are the failure to obtain
independent confirmation of a borrower's income and failure to test a borrower's
capacity to keep making repayments if, over the course of the loan, interest
rates were to increase. As competition intensifies, the strength of banks'
risk management systems for commercial and consumer loans is likely also to
be tested.

We have already expressed our concern that some current lending practices do risk
sowing the seeds of future credit quality problems for banks. This concern
has not increased in recent months. Nor has it diminished.

Indeed, it seems unrealistic to think that average
ROEs of over 15 per cent could continue in a world of 2 per cent inflation and a
return on long bonds between 6 and 7 per cent. One has to go back to the regulated,
less competitive world of the early 1970s to find comparable margins between
bank earnings and bond yields.

Supervision of Bank Capital

I referred earlier to banks managing their capital more actively. The RBA's main
supervision task this year has been extending the capital adequacy rules to
cover the market
risks in banks' trading books –
that is, the risks from fluctuations in interest rates, exchange rates, equity
prices and commodity prices. The new guidelines become effective at the beginning
of 1998.

The novel feature of the market risk guidelines, which were developed by the Basle
Committee on Banking Supervision and are being adopted internationally, is
the reliance they allow to be placed on banks' own risk management systems.
Banks have the option of using their internal models to calculate required
capital, or of employing a standard model specified by the Basle Committee.
Of course, internal models need to meet certain minimum standards – both
quantitative and qualitative – before they will be accepted for supervisory
purposes. A bank whose systems are not up to scratch will have to use the standard
model.

The RBA must sign off on the adequacy of internal systems. But the onus for effective
day-to-day risk management will remain squarely with the boards and senior
management of banks.

As an aside, during the past year we introduced arrangements under which a bank's
chief executive, with the endorsement of the board, must attest to the RBA
that all
key risks have been identified, that systems have been designed to manage those risks,
that the descriptions of those systems held by the RBA are current and that
the systems are working effectively.

We are already seeing important general benefits from these new arrangements. They
have resulted in more high-level attention to risk management systems and the
system descriptions provided to us. Chief executives now need to see those
manuals, which were previously often regarded as an administrative inconvenience
for officers handling liaison with the RBA. This has added discipline and rigour
to the whole risk management process.

Eleven banks have applied to us for internal model status under the market risk rules,
and they are all presently upgrading their existing risk measurement and management
practices to meet the minimum requirements. As well as to measurement methodology,
they are giving attention to such features as the adequacy of separation of
front- and back-office operations, procedures to ensure that traders deal only
in products for which robust operational and legal arrangements are in place,
the rigour of revaluation processes and procedures for stress testing and back
testing. We remain hopeful that, by the end of the year, all internal models
will have reached a standard with which we can be comfortable, but there is
a good deal of work still to be done in some cases.

Another eleven banks plan to use the standard model for market risk, while the remainder
have insufficient market risks to be affected by the new guidelines or are
branches, covered by their home country supervisors.

Our assessment remains that the new arrangements will not add materially to required
capital for the banking system as a whole. However, the impact on individual
capital ratios will vary, depending on the scope of each bank's trading
activities. For some there will be an increase. For others, required capital
may actually fall, as the benefits from substituting specific market risk charges
for existing credit risk capital will outweigh the additional capital needed
for general market risks.

The next question about supervision of banks' capital is whether the present
rules covering credit risk might be replaced by a more sophisticated methodology
more in line with the market risk framework. The current rules are relatively
crude in the sense that capital ratios are applied against very broad categories
of credit exposure without any firm basis in the actual likelihood of loss.

In the way that potential losses from a portfolio of traded instruments can be estimated
using historical data on daily price movements, potential losses from a portfolio
of loans can, in principle, be estimated from an examination of default histories.
Supervisors would add a mark up for safety to these estimates, as they have
in the case of market risk.

Lack of reliable data on defaults and credit losses has been a major obstacle to
this approach. But banks are working to remedy this, and are making progress
toward putting the management of credit risk onto a more objective/scientific
basis. Modelling techniques can be applied more easily to some components of
a loan portfolio – such as high-volume, standard housing and credit card
receivables – than to others. For this reason, an incremental approach
to recognising models for credit risk supervision is likely to emerge.

There is probably quite a way to go before credit risk is generally as amenable to
modelling as market risk is. And since credit risk remains potentially the
greatest threat to the soundness of banks and banking systems, supervisors
are likely to be conservative about changes to the present rules, with all
their imperfections.

Implications of New Government Policies

There is clearly a lot of market-driven change ‘in the pipeline’ for
banks. The Government's policy decisions following the Financial System
Inquiry will further alter the environment for banks and others in coming years.

Those policy changes, announced by the Treasurer early this month, have many dimensions.
I would like to talk about just two of those – effects on competition
in banking and on the payments system.

There is no doubt that the proposed policy changes will increase competition, by
widening the range of potential players in both deposit-taking and in retail
payments. (There will be less change as far as lending is concerned; apart
from the need to conform with the consumer protection provisions of the uniform
credit laws, there are already few regulatory impediments to the entry of new
lenders – as the recent history of home lending shows clearly enough.)

The new rules should add to competition in deposit-taking in several ways.

First, creating a single licensing regime for all deposit-taking institutions (DTIs)
should help to level the proverbial playing field among credit unions, building
societies and banks. A single depositor protection system – based on
depositors having prior claim over the assets of a troubled institution –
will be a key element in this. The actual impact of the new regime on the competitive
standing of the various DTI groups will, of course, depend on the effectiveness
of the smaller institutions in promoting their new status.

Under the single licensing regime banks will still constitute a particular category
among deposit-takers, but distinguished primarily by their size. Only institutions
with at least $50 million in Tier 1 capital, and having a settlement account
with the RBA, will be able to use the label ‘bank’. The single
regulatory regime will, in principle, allow smaller DTIs to grow into this
status more readily than they can now.

Under new policy, mutual organisations will be able to have a banking licence, or
to own a bank – subject, of course, to satisfying prudential qualifications.
Previously, it was possible for mutuals to be associated only with non-bank
DTIs.

It will also be open for banks to be established under non-operating holding company
structures. Until now, with limited exceptions, a bank itself has had to be
the holding company of a financial group. No doubt some groups will, for one
reason or another, see commercial advantage from reorganising an existing operation
under a holding company, or in establishing a new bank under such a structure.
It seems likely that groups with bancassurance or allfinanz
aspirations will go this way.

For some financial groups, the possibility in future of having more than one banking
authority (or licence), or a banking authority and a non-bank deposit-taking
licence, will also be seen as helpful to their competitive position.

Moreover, the Government has foreshadowed that the new licensing agency – the
Australian Prudential Regulation Authority (APRA) – will have a more
flexible attitude to the mixing of financial and non-financial activities in
the one group.

But this does not mean ‘open slather’. The general presumption in favour
of dispersed ownership of banks and other deposit-takers will remain –
with individual shareholdings above 15 per cent needing to pass a national
interest test. And there will be a ‘demonstrable congruity’ test
for non-financial activities to sit alongside a bank in a conglomerate. The
interpretation and administration of this test will be for the new agency,
but the Treasurer has referred to cases ‘where financial products can
be logically bundled with a supply of non-financial goods and services’,
and has indicated that APRA's assessment of applications will be guided
by international trends.

One can readily imagine activities such as information-processing and communication
of various kinds passing a congruence test. There could well be others over
time.

Incidentally, the intention clearly is that licensed deposit-takers will still be
distinct legal entities with dedicated capital, separate management systems
and so on. A non-financial company might be able to own a bank, but it could
not be licensed in its
own right as a bank or other deposit-taker.

One can only speculate about the exact effects of these reforms on the evolution
of banking and finance in Australia over coming years. These effects will be
intermingled with those of technological change, global pressures, the administration
of merger policy, and so on.

But it seems clear enough that more flexibility in entry rules for new players, and
more flexibility in corporate structures, will add to competition and make
life a little tougher (at least) for the established deposit-takers. This will
be another force bearing down on margins and profitability.

One should not forget, of course, that these policy reforms will open up opportunities
(such as for holding company structures) previously denied to existing players
too. And the eventual elimination of the non-callable deposit regime will remove
another sort of unevenness in the playing field – one which currently
penalises authorised banks relative to the non-bank DTIs and merchant banks.

Let me turn now to the payments system where similar forces will be at work. From
the RBA's perspective there are three main changes in store.

One is that participants in the payments system, other than deposit-takers, could
qualify for an exchange settlement account (ESA) at the RBA. The Treasurer's
statement said: ‘While the immediate scope for greater access is likely
to be limited, access will not be constrained to licensed banks or other deposit-taking
institutions’. New opportunities might, consequently, be available to
companies offering payment services based on credit facilities, such as credit
cards. With an ESA, they would be able to offer final settlement of payment
obligations to other institutions in their own right, rather than having to
negotiate an agency arrangement with a bank.

While the details are yet to be worked out – by the RBA in this case –
two prerequisites for ESA access will be:

no reduction in the safety and stability of the payments system; and

access only for institutions which provide, or propose to provide, extensive third
party transactions (as opposed to companies making transactions on their own
account).

Again, we are not talking ‘free-for-all’, but we are talking a markedly broader range of payments opportunities for
non-traditional players.

A second change is that the RBA will have regulatory power over widely used stored-value
instruments – such as cards, internet tokens and even travellers'
cheques – where their issuer is not a licensed deposit-taker. This will
be prudential regulation aimed at reducing systemic risks and preserving public
confidence in the various forms of electronic cash.

The more general, and most significant, reform in payments policy is that the RBA
will be given formal, statutory responsibilities for the payments and settlements
system, with powers to back them up. Its responsibilities will cover not only
issues of stability and safety, but will extend to the efficiency and competitiveness
of the system, including questions of fair access for new payments providers.
The RBA will be required, for instance, to look into the fees and charges levied
by the established players on newcomers wishing to join existing networks,
or to use existing infrastructure.

To carry out these responsibilities, we will need to develop criteria for assessing
the acceptability of membership and third party access provisions in the various
payments clearing streams. We will also produce and publish benchmarks for
judging the safety and efficiency of Australia's payments system.

When the RTGS system commences for high-value payments in the first half of 1998,
a major step will have been taken to reduce risk and improve safety in domestic payments. We will be encouraging as many payments
as practicable to move onto that system. The next major frontier is to reduce
the settlement risks of Australian banks in their international transactions.
This will be, if anything, more challenging than domestic RTGS has been, but
some progress is being made internationally.

I suspect that there is as much to be done to improve the efficiency of the Australian payments system and the fairness
of access arrangements to retail payments streams. The ACCC has recently found
wanting the basis on which smaller players may negotiate participation in the
EFTPOS system.

I should emphasise that it will be the RBA's intention to adopt as light a regulatory
touch as possible over the payments system. There has, after all, been a good
deal of recent progress in reforming that system without the Bank having explicit
powers. We hope such progress will continue – through the Australian
Payments Clearing Association and other industry-based bodies. Only where payments
arrangements fall short of our efficiency and safety benchmarks – and
there are no serious attempts by the industry to rectify that position reasonably
quickly – will we embark on the path of prescriptive regulation.

End Piece

It is a truism that change is always with us. But I suspect that banks face more
than their fair share of it in coming years. I hope my remarks will be useful
background for your speculation about the details of this change over the next
couple of days.